Did Dr. Pangloss receive his Ph.D. in economics? It would seem so.
At Voltaire’s CandideDr. Pangloss declared it to be the best of all possible worlds, despite the evidence surrounding it. And sure enough, things are looking up, markets and the media are increasingly agreeing, at least in terms of lower inflation.
But they may cast a panglossian shadow over improvement and ignore underlying but still elusive aspects. Price pressures are easing, albeit from their worst levels in four decades last year. Markets expect not only a slowdown in the pace of Federal Reserve rate hikes, but also a tapering by the end of 2023, although inflation will still exceed the central bank’s 2% target, while forecasts of a recession remain just predictions. , not a fact.
The last reading of the consumer price index coincided with the optimistic estimates of economists. Broadly watched inflation actually fell 0.1% in December, largely due to a 9% drop in gasoline prices. The so-called core rate, which excludes food and energy costs, rose 0.3%, in line with forecasts. Furthermore, core CPI slowed to an annual growth rate of 5.7% from a 40-year peak of 6.7% in September.
But Michael Lewis, head of the Free Market consultancy, cautions that other measures that dig deeper into the data “may tell a different, less sanguine but more accurate story,” he wrote in a client note. The Atlanta Fed’s measure of “sticky” prices rose 6.7% from a year earlier, while the Cleveland Fed’s average CPI rose 6.9% over the period, showing a small net improvement over the past year.
Instead of just throwing out food and energy like the core CPI does, Cleveland pulls out the most volatile items each month, while Atlanta focuses on the most stable prices. Fed Chairman Jerome Powell has previously cited these measures. Lewis says these data are the main reason he cautioned against overconfidence in the central bank’s fight against inflation.
Medical care services have been the main factor holding back inflation, at least as measured by the Bureau of Labor Statistics. The category rose just 0.1% in December, following declines of 0.7% and 0.6% in the previous two months, respectively. That reduced annual growth in medical care services to 4.1% in December, which Citi economist Veronica Clark called “misleadingly soft.” That spending is likely to show a sharper increase in the December producer price index to be reported this coming week, which would mean more for the Fed’s preferred inflation gauge, the main deflator of personal consumption, he wrote.
Another alternative measure of Powell’s radar has been basic services, excluding housing costs, which account for nearly a third of the total CPI. Fans of the measure say the BLS method reflects the lagged effect of past growth and ignores the recent decline in the rate of rent increases seen in Zillow’s online measures.
This “core core” ex-housing series is a novelty in tracking inflation because it is driven by the most important labor costs. Inflation optimists’ hopes were bolstered by a slowdown in average hourly earnings, rising to 4.6% in December from a year earlier. But the broader measures favored by the Fed are likely to put more pressure on labor costs.
The Employment Cost Index is only published quarterly, but is a much more comprehensive measure that includes changes in the composition of the labor force and benefits in addition to wages and salaries. Compensation costs rose 5.0% in the 12 months ended Sept. 30, and 5.2% for private sector workers.
The next ECI will be released on January 31, the first day of the upcoming Federal Open Market Committee meeting, which will announce its rate decision the following day. Look for a continuation of relatively brisk wage growth reflecting tighter working conditions, as evidenced in the latest Job Openings and Labor Turnover Survey and the National Federation of Independent Business, said Joshua Shapiro, MFR’s chief U.S. economist.
Such a pace of labor cost growth would be consistent with inflation falling closer to the Fed’s 2% target only if productivity were strong. But Neil Dutta, head of economics at Renaissance Macro Research, notes that productivity growth has been slow, at only about 1%, against a 5% rise in labor costs.
The risk for the Fed is that it could hold off on raising rates while the economy is actually accelerating, as opposed to when it raised rates sharply during a slowdown last year, he warns. Futures markets are pricing in a quarter-point increase to 4.75%-5% at the next two FOMC meetings, which would mark the peak, according to the CME FedWatch website.
Overall financial conditions have weakened markedly, Dutta said, reflecting falling Treasury yields, credit spreads in the mortgage and corporate markets, rising stock prices, and especially the sharp fall in the dollar in recent months. The traditional notion of monetary policy with “long and variable lags” is flawed, he says. Instead, delays have become “short and predictable” by working through financial markets. Reflecting this, Dutta notes, housing stocks are “on tear,” up nearly 40% from mid-2022 lows.
Despite steady inflation and the absence of a recession, with unemployment at a record low of just 3.5%, markets expect the Fed to hold off on hikes and then cut interest rates by the end of the year. Based on this disjointed reading of the underlying data, the markets’ optimism that fueled the rally in bonds and stocks may be misplaced.
Sorry, Dr. Pangloss.
Write Randall W. Forsyth at [email protected]